Report of the National Commission on Fraudulent Financial Reporting October 1987 Copyright (c) 1987 by the National Commission on Fraudulent Financial Reporting National Commission on Fraudulent Financial Reporting COMMISSIONERS Chairman Hugh L. Marsh James C. Treadway, Jr. Director Executive Vice President and Internal Audit General Counsel Aluminum Company of America Paine Webber Incorporated Thomas I. Storrs William M. Batten Chairman of the Board (Retired) Chairman (Retired) NCNB Corporation New York Stock Exchange Donald H. Trautlein William S. Kanaga Chairman and Chief Executive Chairman of the Advisory Board Officer (Retired) Arthur Young & Company Bethlehem Steel Corporation STAFF Executive Staff G. Dewey Arnold, Executive Director Jack L. Krogstad, Research Director Catherine Collins McCoy, Deputy Executive Director and General Counsel Professional and Technical Staff Senior Consultants Joseph A. Adams Lawrence C. Best Angela L. Avant Allan Wear Louis Bisgay Mark P. Connelly Editorial Consultant Paul C. Curtis Carol Olsen Day George F. Daly Joseph J. Donlon Administrative Staff Michael Doyle Michael R. Funderburg Alma Fagan Laura S. Greenstein Catherine Fonfara John F. Harris Vicki Johnston Ellen Downey Hylas Sandra Ringer Joseph Janella Scott J. Ludwigsen Lawrence D. Morriss, Jr. Timothy G. O'Connor Gary A. Rubin Shirley Sunderland iii ADVISORY BOARD MEMBERS Donald W. Baker P. Norman Roy Vice President-Controller Executive Vice President Southwire Company Barry Wright Corporation (National Association of Accountants) (Financial Executives Institute) William G. Bishop, III Robert J. Sack Executive Vice President Chief Accountant Corporate Audit Department Division of Enforcement Shearson Lehman Bros., Inc. Securities & Exchange Commission (Institute of Internal Auditors) Philip B. Chenok A. Clarence Sampson, Jr. President & Chief Staff Officer Chief Accountant American Institute of Certified Securities & Exchange Commission Public Accountants Frank S, Sato William J. Duane, Jr. Inspector General General Auditor Veterans Administration Manufacturers Hanover Trust Company (Institute of Internal Auditors) Jerry D. Sullivan Partner James J. Leisenring Coopers & Lybrand Director of Research & (Chairman, Auditing Standards Board) Technical Activities Financial Accounting Standards Board Doyle Z. Williams Dean, School of Accounting Richard M. Phillips University of Southern California Kirkpatrick & Lockhart (American Accounting Association) (American Bar Association) iv TABLE OF CONTENTS Introduction 1 Summary of Recommendations 11 Chapter One: Overview of the Financial Reporting System and Fraudulent Financial Reporting 17 Chapter Two: Recommendations for the Public Company 31 Chapter Three: Recommendations for the Independent Public Accountant 49 Chapter Four: Recommendations for the SEC and Others to Improve the Regulatory and Legal Environment 63 Chapter Five: Recommendations for Education 79 Appendices 87 v LIST OF APPENDED MATERIAL Appendix A Biographies of Commissioners and Executive Staff 91 B Summary of External Research Program 95 C Summary of Research Reports and Briefing Papers Prepared by Commission Staff 109 D Persons Consulted by the Commission 121 E Composite Case Studies in Fraudulent Financial Reporting, Harvard Business School 125 F Good Practice Guidelines for Assessing the Risk of Fraudulent Financial Reporting 153 G Standards for the Professional Practice of Internal Auditing, The Institute of Internal Auditors 165 H New York Stock Exchange Listed Company Manual, Section 3, Corporate Responsibility-Audit Committee 177 I Good Practice Guidelines for the Audit Committee 179 J Good Practice Guidelines for Management's Report 183 K Good Practice Guidelines for Audit Committee Chairman's Letter 187 vi 1 INTRODUCTION This report presents the findings, conclusions, and recommendations of the National Commission on Fraudulent Financial Reporting (the Commission), From October 1985 to September 1987, the Commission studied the financial reporting system in the United States. Our mission was to identify causal factors that can lead to fraudulent financial reporting and steps to reduce its incidence. Fraudulent financial reporting is indeed a serious problem. Infrequent though its occurrence arguably may be, its consequences can be widespread and significant. Although fraud in any form can be difficult to deter, fraudulent financial reporting can be reduced, perhaps substantially, if each party for whom we made recommendations takes the steps we recommend. The Commission's recommendations embrace the top management and boards of directors of all public companies, independent public accountants and the public accounting profession, the SEC and other regulatory and law enforcement bodies, and the academic world. As background to the Commission and its work, this introduction discusses the Commission's sponsors, members, and advisors, the definition of fraudulent financial reporting that the Commission used, the Commission's objectives, the scope of the study, and the research program. Following this background information is a discussion of the major conclusions that guided the Commission in developing the recommendations presented in this report. I. The Commission Sponsors, Members, and Advisors The Commission was a private-sector initiative, jointly sponsored and funded by the American Institute of Certified Public Accountants (AICPA), the American Accounting Association (AAA), the Financial Executives Institute (FEI), the Institute of Internal Auditors (IIA), and the National Association of Accountants (NAA). The six-member Commission was independent of the sponsoring organizations. The chairman of the Commission was James C. Treadway, Jr., formerly a Commissioner of the Securities and Exchange Commission (SEC), and presently Executive Vice President, General Counsel, member of the Executive Group, and a Director of Paine Webber Incorporated. William M. Batten is the immediate past Chairman of the New York Stock Exchange and the former Chief Executive Officer (CEO) of J.C. Penney Co. William S. Kanaga is Chairman of the Advisory Board of Arthur Young & Company, and served as Chairman of that firm and of the AICPA. Hugh L. Marsh is the Director-Internal Audit for ALCOA, responsible for its worldwide audit activities. He also is a past Chairman of the IIA. Thomas 1. Storrs is the immediate past Chairman and CEO of NCNB Corporation, a bank holding company, and continues to serve as a Director of NCNB. Donald H. Trautlein recently retired as Chairman and CEO of Bethlehem Steel and was formerly a partner with the accounting firm of Price Waterhouse. Appendix A includes biographies of the Commissioners and the Executive Staff. 2 An Advisory Board, representing a broad spectrum of experience and points of view, assisted the Commission. Definition of Fraudulent Financial Reporting For purposes of this study and report, the Commission defined fraudulent financial reporting as intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements. Fraudulent financial reporting can involve many factors and take many forms. It may entail gross and deliberate distortion of corporate records, such as inventory count tags, or falsified transactions, such as fictitious sales or orders. It may entail the misapplication of ac- counting principles. Company employees at any level may be involved, from top to middle management to lower-level personnel. If the conduct is intentional, or so reckless that it is the legal equivalent of intentional conduct, and results in fraudulent financial statements, it comes within the Commission's operating definition of the term fraudulent financial reporting. Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors. The Commission also distinguished fraudulent financial reporting from other corporate improprieties, such as employee embezzlements, violations of environmental or product safety regulations, and tax fraud, which do not necessarily cause the financial statements to be materially inaccurate. Objectives The Commission had three major objectives: 1. Consider the extent to which acts of fraudulent financial reporting undermine the integrity of financial reporting; the forces and the opportunities, environmental, institutional, or individual, that may contribute to these acts; the extent to which fraudulent financial reporting can be prevented or deterred and to which it can be detected sooner after occurrence; the extent, if any, to which incidents of this type of fraud may be the product of a decline in professionalism of corporate financial officers and internal auditors; and the extent, if any, to which the regulatory and law enforcement environment unwittingly may have tolerated or contributed to the occurrence of this type of fraud. 2. Examine the role of the independent public accountant in detecting fraud, focusing particularly on whether the detection of fraudulent financial reporting has been neglected or insufficiently focused on and whether the ability of the independent public accountant to detect such fraud can be enhanced, and consider whether changes in auditing standards or procedures internal and external would reduce the extent of fraudulent financial reporting. 3. Identify attributes of corporate structure that may contribute to acts of fraudulent financial reporting or to the failure to detect such acts promptly. Scope: Public Companies The Commission's study focused on public companies. The term public company generally includes companies owned by public investors. Several types of companies fall within the Commission's definition of public company: (1) public companies that report to the SEC; (2) certain publicly owned banks, savings and loan associations, and other financial institutions that are subject to the disclosure provisions of the federal securities laws but report to one of the financial institution regulatory agencies; and (3) certain mutual thrift institutions. 3 The Commission included public companies of this third type for several reasons. The same federal agencies that regulate the publicly owned financial institutions regulate these mutual thrift institutions. Their ownership by depositors resembles public ownership since these companies accept public funds as capital and give depositors equity-like interests. A number of cases of fraudulent financial reporting have occurred in these institutions, with far-reaching impact. The Commission's focus should not imply that fraudulent financial reporting occurs only in public companies or that only in these companies is its impact noteworthy. On the contrary, fraudulent financial reporting has occurred, often with serious consequences, in entities that are outside the express scope of the Commission's study and recommendations. Among the "non-public company" entities that are at risk of fraudulent financial reporting are some entities, such as mutual insurance companies, that may in fact accept public funds as capital. Others at risk include state-regulated banks, private defense contractors and private companies in general, as well as various government and quasi-government entities. In the Commission's estimation, the overall thrust of the recommendations-especially the emphasis on top management's responsibility-is relevant and applies to all these "non-public company" entities. Applied with proper reflection, foresight, and ingenuity, many of the Commission's recommendations should prove practicable, cost-effective, and suitable for these other entities to implement. Accordingly, the Commission urges "non-public company" entities to use the recommendations in forming individual or collective responses to the problem of fraudulent financial reporting. Research Program and Interviews A thorough understanding of the environment in which fraudulent financial reporting occurs is a prerequisite to identifying appropriate responses. Too often, the subject has been considered from a narrow perspective. The Commission placed a high priority on going deeper than the obvious in identifying the many forces and opportunities that may contribute to financial reporting fraud. To this end, the Commission directed an extensive research program. Outside experts who conducted research projects for the Commission considered professionalism and codes of corporate conduct, corporate pressures, surprise writeoffs, internal control, internal auditing, the role of the SEC, litigation against public accountants, the independence of the public accountant, computer fraud, and business and accounting education. In addition, the Commission's staff completed more than 20 research projects and briefing papers, including analyses of SEC enforcement actions, pressures within public accounting firms, AICPA self- regulatory programs, and the legal and regulatory environment. Significant findings of the research efforts are incorporated into the text of the report, and Appendices B and C summarize the research. To supplement this research program, the Commission reviewed previous and current related studies and interviewed numerous experts. The related studies the Commission reviewed are listed in Appendix C. The Commission interviewed the Chairman of the SEC, the Chairman of the Federal Deposit Insurance Corporation, the Comptroller of the Currency, the Comptroller General of the United States, the Chairman of the AICPA, the Chairman of the Auditing Standards Board, the Chairman of the AICPA's SEC Practice Section's Public Oversight Board, the Chairman of the IIA, the President of the FEI, the President of the NAA, the President of the National Association of State Boards of Accountancy, several members of the Commission's Advisory Board, and many other independent public accountants, government regulators, corporate executives, and university professors. Appendix D lists the persons the Commission consulted. 4 Exposure Draft, Public Comment, and Congressional Hearings The Commission first voted on the recommendations in October 1986. Thereafter, members of the Commission and the staff delivered several speeches airing the Commission's initial findings and conclusions to "pre-expose" the Exposure Draft of the report and thus start the comment process in advance of the draft's publication in late April 1987. In addition to those who conveyed their reactions, suggestions, and opinions informally during the pre- exposure period, approximately 50 interested organizations and individuals expressed their points of view in written comments. The Commission considered all the comments-positive, negative, and neutral- in its deliberations. In a number of areas, the recommendations in the Exposure Draft bore the imprint of these comments. The Commission's five sponsoring organizations distributed over 40,000 copies of the Exposure Draft. Requesting and welcoming public comment, the Commission received over 200 letters in reply. These responses represented the views of substantially more than 200 interested parties, since many of them presented the collective comments of members of professional and trade organizations, including the Commission's five sponsoring organizations, as well as large national accounting firms, state and federal agencies, leading financial service institutions, and Fortune 500 companies. The process of reviewing, analyzing, and considering the comment letters was indispensable to the Commission in completing and issuing the report. The overwhelming majority of responses complimented the Commission on its overall effort and were generous in their support of the Commission's recommendations. Those who expressed selective disagreement or raised particular concerns with regard to one or more of the recommendations made many insightful comments and constructive suggestions. The report includes a number of changes made to reflect the commentators' suggestions, criticisms, and other viewpoints. The comment letters, part of the permanent record of the Commission's work, are available to the public on request through the offices of the AICPA in New York. Finally, the Commission appeared twice before the House Committee on Energy and Commerce's Subcommittee on Oversight and Investigations, as part of the Subcommittee's continuing inquiry into the adequacy of auditing, accounting, and financial reporting practices under the federal securities laws. II. Major Guiding Conclusions The Commission's recommendations, taken together, form a balanced response to fraudulent financial reporting. The Commission cannot overemphasize the importance of evaluating its recommendations in their totality; no one is meant to be singled out from the rest. Indeed, the Commission withheld endorsement of any recommendation under consideration until the research and briefing papers for substantially all recommendations had been completed and the Commission could see the web of relationships among the proposed recommendations. From the outset, the Commission's goal was to develop recommendations that would be practical, reasonable in the circumstances, justified by the benefits to be achieved, and would lend themselves to implementation without undue burden. Guiding the Commission in this task were a number of conclusions. [...]... fraudulent financial reporting Participants in the Financial Reporting Process The responsibility for reliable financial reporting resides first and foremost at the corporate level Top management-starting with the chief executive officer-sets the tone and establishes the financial reporting environment Therefore, reducing the risk of fraudulent financial reporting must start within the reporting company... prosecution for fraudulent financial reporting should be made a higher priority Improved Regulation of the Public Accounting Profession Another regulatory function, the regulation of the public accounting profession, seeks to reduce the incidence of fraudulent financial reporting through ensuring audit quality and thereby enhancing early detection and prevention of such fraud The Commission studied the. .. Accordingly, the Commission urges legal, financial, and other advisors to support its recommendations and to consider them in forming their own response to the problem of fraudulent financial reporting 7 The efforts of these advisors to form a response to the problem of fraudulent financial reporting will necessarily entail reassessing their legal and professional responsibilities and accountability, not only... deliberations Similarly, the Commission outlines some of the numerous opportunities for public companies to educate their directors, management, and employees about the problem of fraudulent financial reporting 16 Chapter One OVERVIEW OF THE FINANCIAL REPORTING SYSTEM AND FRAUDULENT FINANCIAL REPORTING I Background to the Report Before developing recommendations responsive to fraudulent financial reporting, ... The following exhibits illustrate the functional relationships among these components Exhibit 1-1,page 18, illustrates the relationships of the three major groups in the financial reporting system to one another and to those who use publicly reported financial information The company and its management are the key players in the financial reporting system; they bear the primary responsibility for the. .. bear the loss of the public's trust and confidence in the integrity of the financial reporting system The Spirit of the Recommendations The Commission urges all participants in the financial reporting process to implement both the substance and the spirit of its recommendations The Commission nonetheless recognizes that the resources to implement its recommendations in smaller public companies and smaller... that our report will serve as a framework for action now and as a springboard for future efforts to reduce fraudulent financial reporting 9 10 SUMMARY OF RECOMMENDATIONS This summary is a synopsis of the organization and content of the Commission' s recommendations, which appear in Chapters Two through Five of the report The Commission urges readers to consider the recommendations along with the accompanying... recommendations I Recommendations for the Public Company (Chapter Two) Prevention and earlier detection of fraudulent financial reporting must start with the entity that prepares financial reports Thus the first focus of the Commission' s recommendations is the public company These recommendations, taken together, will improve a company's overall financial reporting process and increase the likelihood of preventing... sponsoring organizations cooperate in developing additional, integrated guidance on internal controls Internal Accounting and Audit Functions The Commission' s recommendations turn next to the ability of the participants in the financial reporting process within the company to prevent or detect fraudulent financial reporting The internal accounting function must be designed to fulfill the financial reporting. .. changes, as do the methods by which fraudulent financial reporting occurs The Commission' s recommendations therefore cannot stand for all time as the most appropriate responses to the problem Continued studies of fraudulent financial reporting and its prevention and detection will be necessary Two examples of societal changes that can affect fraudulent financial reporting are the Tax Reform Act of 1986 and . Report of the National Commission on Fraudulent Financial Reporting October 1987 Copyright (c) 1987 by the National Commission on Fraudulent Financial. recommendations of the National Commission on Fraudulent Financial Reporting (the Commission) , From October 1985 to September 1987, the Commission studied the financial